The “To Be Announced” (TBA) market is a market for forward commitments to buy and sell standardized mortgage backed securities (MBS). The market gets its name from the fact that the identity of the actual securities changing hands is not known until just before settlement. The TBA market facilitates trading in fixed-rate MBS created under the auspices of the three agencies, with coupons in even 50 basis point increments (i.e., coupons of 4.0%, 4.5%, etc.) for multiple consecutive settlement months. Monthly settlements take place on days designated by the industry trade association.
The actual pools used to satisfy open TBA commitments are created prior to settlement and delivered against the open TBA commitment at settlement. Two business days prior to settlement, the seller provides the buyer with a list of the pools that will be delivered against the TBA commitment. The pools must meet the trade association's specifications for good delivery. These rules dictate the types of pools that can be delivered against a TBA commitment, how many pools can be delivered (typically three pools per million dollars in face value), and the “delivery variance” (i.e., the difference between the face value of pools to be delivered and the TBA commitment size). The pools are then delivered, versus a cash payment, by the seller to the buyer on the settlement date. (See FIG. 1 for a schematic of the trade and settlement processes.) If the information is not conveyed by the cutoff time (3:00 PM Eastern Time) or the information does not meet the trade association's delivery rules, the buyer can refuse to accept delivery of the pools. This eventuality (“failing to deliver”) means that the seller must hold the pools until delivery can be affected, incurring both capital outlays and expenses.
The fact that the TBA market allows trading to take place for multiple months' settlement facilitates transactions known as dollar rolls. Dollar rolls (or simply “rolls”) are trades where TBAs are bought (sold) for a particular month's settlement and simultaneously sold (bought) for a later settlement.
The TBA market is the primary vehicle for mortgage-backed securities (MBS) trading. Data from the Financial Institution Regulatory Authority (FINRA) indicates that TBA trades regularly constitute more than 90% of all trading in MBS.
The structure of the TBA market reflects the needs of several market segments. Mortgage lenders can use TBA forward commitments to hedge their “pipelines” of loan applications that are in the process of being underwritten, while also monetizing their funded inventories by delivering against their TBAs. Investors also utilize the TBA market to buy and sell MBS pools. Investors” include a variety of market participants that utilize TBA commitments, including money managers, hedge funds, and mortgage servicers. The market is facilitated by Broker/Dealers who act as intermediaries between various counterparties. In order to act as intermediaries, Broker/Dealers must 1) act as a counterparty for lenders and investors looking to buy or sell TBAs (as well as actual pools); 2) accept and deliver pools to fulfil TBA forward trades; and 3) evaluate and manage counterparty credit risk. This requires capital, trading and risk-management personnel, back-office staffing, information and analytical technology, and banking facilities.
FIG. 2 shows a schematic showing the structure of the MBS market and the various participants. Broker/dealers act as market intermediaries. They will take the opposite side of trades from their clients, acting as either an agent (i.e., risklessly) or as a principal (accepting market risk). Lenders typically receive pools from the agencies (Fannie Mae, Ginnie Mae, Freddie Mac) and deliver them to broker/dealers against TBA forward commitments. Lenders typically do not buy TBAs except to close out open short positions; as a result, their inability to take delivery of pools from any counterparty other than the agencies is limited. Investors buy or sell TBAs depending on their investment strategies and tactics, and often receive or deliver pools against TBA obligations. (They also have the option of closing out trades prior to settlement.) As part of the settlement process, broker/dealers receive pools from sellers and re-deliver them to buyers. Acting as a broker/dealer for TBAs requires: Counterparty credit exposure and analysis; Staffing, IT infrastructure, and banking facilities to accept and deliver pools to counterparties; Capital and financing necessary to support a principal trading operation and to fun positions resulting from “fails.” Counterparties (i.e., both lenders and investors) typically never interact directly with each other. Reasons include: Operations are simplified by facing a limited number of counterparties; Counterparty credit exposure is limited to a few large, well-capitalized and regulated entities.
The TBA market's structure makes the settlement process for MBS complex and expensive, and errors are common. The following compares the settlement procedures for Treasury futures contracts (traded and settlement through the CME Group) relative to the TBA market.
CBOT Treasury futures are settled by delivering eligible securities against trades for trades open at expiration of quarterly contracts. Eligible securities are delivered through the exchanges clearing bank. Trade prices are adjusted using “conversion factor” for the security delivered. Each contract has a “delivery basket” outlining the securities that can be delivered. For example, the 10-year note future allows delivery of Treasuries with maturities between 6½ and 10-years. For the September 2017 10-year note contract, 16 issues were eligible for delivery. Delivery may occur on any day of the month the contract expires, up to and including the last business day of the month. CME Clearing acts as counterparty on all open transactions, and is responsible for managing client accounts, collecting margin, and managing credit exposure.
TBA forward commitment settlements take place monthly for all coupons and products according to a calendar published by SIFMA. The seller must notify the buyer of the identity and face value of pools to be delivered against open obligations, subject to SIFMA delivery rules. Pools are delivered subject to SIFMA rules that specify a) eligible product groups; b) the maximum number of pools per million to be delivered (3); c) the maximum delivery variance (0.01%). Deliveries that do not meet these rules are not accepted by the buyer and may result in “failing to delivery.” More than 37,000 pools can be delivered against Fannie Mae 3.5% TBAs. In 2016 Fannie Mae issued 6,435 pools that are eligible for delivery, with sizes ranging from $57,500 to $26.0 billion. Seller must notify buyer of pool IDs and face values no later than 48 hours prior to settlement (3:00 PM Eastern Time on the assigned settlement date). Broker/dealers serve as counterparties against virtually all trades. They take delivery of pools from accounts selling to them and re-deliver them against their sales, and must fund pools that cannot be delivered by settlement. Broker/dealers also collect margin and manage counterparty credit exposure.
Mortgage lenders and MBS traders often find it convenient and cost-effective to trade options due to the intrinsic nature of the products. Mortgages are noteworthy for having “embedded” options that reflect the borrowers' ability to refinance their loans if rates decline. In addition, mortgage lenders must deal with the possibility that loan applicants will either abandon their applications or negotiate lower mortgage rates if market interest rates decline between the time that their loans' rate is set (or “locked”) and the time the loans close. This is referenced as “fallout” and is another form of option embedded in loan applications. Lenders monitor the expected fallout from their pipeline by estimating a “Pull-Through Rate” which estimates the proportion of their pipeline that they expect to close. The Pull-Through Rate for a loan is a function of the current level of mortgage rates (relative to the loan's rate) as well as the underwriting status of the loan. (If a loan is approved and an appraisal has been performed, for example, the borrower is unlikely to seek a new loan irrespective of the level of mortgage rates.) The weighted average Pull-Through Rate for each loan is the Pull-Through Rate for the total pipeline, which dictates the size of the hedges that will be necessary to protect the pipeline's value.
Changes in expected Pull-Through Rates impact the interest rate risk associated with lenders' pipelines. FIG. 3 contains a hypothetical example of how changes in market interest rates impact a pipeline's Pull-Through Rate and necessitates adjustments to the size of the hedge. As rates change, the pipeline effectively increases in size and risk as the Pull-Through Rate increases; as rates fall, the pipeline's size decreases. This behavior means that the lender must re-size the hedges as rates fluctuate in order to avoid being under- or over-hedged. A decision tree illustrating a trader's thought process is shown in FIG. 4. However, hedging with interest-rate options can offset the impact of changing Pull-Through Rates.
The risk exposures or “deltas” of options change based on changes in market conditions, allowing traders to structure hedges that mitigate much of their exposure to embedded options. Delta is a term that indicates the sensitivity of an option's price relative to price changes in the underlying securities. FIG. 5 shows the profile of a hedged pipeline if put options on Fannie 3.5% s are used as a hedging vehicle. As the table indicates, the lender does not need to actively manage the hedge; the hedge's risk exposure changes with the level of market rates, largely offsetting the impact of the embedded options.
While many MBS market participants can benefit from using options, there are several factors that have prevented them from being widely utilized. Because of the complexities and costs associated with the settlement process, there is currently no exchange-traded market for TBA options. Exchanges do not have the same capital and operational structures as broker/dealers, and are unable to absorb the costs, investment and risks associated with allocating and clearing TBA transactions. For example, consider a case where Investor A was short 100 mm TBAs to the exchange, and the exchange was short 100 mm TBAs to Investor B. This is ostensibly a matched trade; however, if pool information is not conveyed on a timely basis to Investor B the exchange might not be able to re-deliver the pools allocated to it by Investor A. As a result, the exchange would need to both allocate capital and obtain financing in order to hold the 100 mm in MBS. Alternatively, they cannot assign trades to their counterparties (i.e., have their counterparties settle transactions directly) in part because of counterparty credit exposures. As a result, TBA options are traded in an Over-The-Counter (OTC) market offered by a small number of dealers. The market is generally viewed as opaque, expensive, and prone to manipulation, and has not grown or expanded since the 1980s despite the expressed interest of many market participants in utilizing options as a hedging and trading vehicle.
Mortgage and MBS traders seeking to utilize exchange-traded options are currently limited to options on Treasury futures. These are often unsatisfactory vehicles because a) the risk exposures of Treasury futures are different than those of mortgages and MBS; and b) Treasury futures and MBS prices often do not exhibit strong correlation. This “basis risk” is difficult to manage and creates a separate form of exposure that many MBS market participants seek to avoid.
The inability and/or unwillingness of mortgage lenders to utilize interest rate options in their hedging directly impacts their financial performance and, by implication, the mortgage rates they can offer to their customers. If a TBA option existed that addressed the various issues addressed previously, lenders could arguably hedge their pipelines more efficiently and become more competitive in their rate offerings.
Option expirations cannot coincide with the TBA settlement calendar due to the pool notification and delivery requirements associated with TBAs. The options must expire prior to the TBA notification date; there must be a lag between expiration and notification day in order to allow pool information to be exchanged prior to the notification deadline. This creates a separate deadline for lenders and investors that requires additional attention and oversight.